Ted Scott, director global strategy at F&C, discusses how comments by the Federal Reserve have led to a loss of investor confidence in emerging markets.

Despite the bullish reaction to the Fed’s comments from City analysts, global financial markets took a different view. Bond yields in other countries, especially emerging markets (EM) rose sharply, and credit also suffered a sell-off. Equity markets suffered their first significant correction for almost a year with only the US remaining relatively resilient. The increased risk aversion also affected currencies with the traditional safe havens, the Japanese Yen and Swiss Franc, rising while EM currencies experienced significant depreciations, which added to losses for overseas holders of EM assets.

• Unintended consequences of rise in US Treasury yields: Bond yields have risen sharply in EM and have been coupled with large falls in local currencies and equity markets. This has raised fears of an impending EM crisis such as occurred in 1997-8 and contributed to a sell-off in financial assets around the world.

• Could the current uncertainty lead to a new EM crisis? The current uncertainty has led to a rapid outflow of funds from the region which has contributed to the sharp decline in EM currencies, government bond prices and equity markets. We have seen several examples of EM policy makers trying to arrest the trend which has been gathering pace.

Ted Scott concludes:

“The recent decline in EM reflects a change in the risk dynamics in financial markets. There has been a noticeable increase in volatility across all financial assets triggered by the rise in US Treasury bond yields in response to the QE tapering debate. Also, earlier doubts about the implementation and efficacy of the new Japanese economic programme have added to the current uncertainty.

“While the market’s attention has been focused on the Eurozone and the management of its debt crisis it is ironic that EM and Japan have provided the renewed source of volatility, albeit triggered by a rise in US Treasury yields. It remains to be seen if the policy makers in Japan, EM and elsewhere can also be galvanised into taking action by the extreme reaction in markets to soothe the fears of investors this year as well.”